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What’s Your Retirement Inflation Risk?

What’s Your Retirement Inflation Risk?

There are two main drivers of asset class returns-inflation and growth. — Ray Dalio

Ray Dalio should know something about investment returns, as he started the Bridgewater investment company in a small apartment in 1975, and Bridgewater now encompasses the world’s largest hedge fund, worth many billions. Unlike Dalio, many investors underappreciate the role of inflation in their investments and how it has a negative impact on purchasing power. It’s especially harmful to those living on a fixed income in retirement.

Word Inflation on up trend arrow, with financial data visible on the background.
Image source: Getty Images.

Here’s a closer look at inflation and its role in your financial life and retirement.

Incredible shrinking purchasing power

Most of us are familiar with the way that prices for all kinds of things tend to go up over time. Maybe you remember buying a nice new car for $10,000 years ago while a similarly nice new car today might sell for $20,000. If you expect to travel in 25 years, know that a plane ticket that costs $400 today could cost $800 or more in 25 years. That’s inflation.

Inflation can be measured in various ways, and the most common measure of it is the “urban” (i.e. non-farmer, non-military, non-institutionalized) Consumer Price Index (CPI), which measures, year by year, the cost of a basket of common goods and services we Americans purchase. Those goods and services include food, clothing, housing, medical care, energy, and so on.

As prices for things rise, it challenges a fixed income — which is, in part, at least, what many people live on in retirement. Social Security benefits are adjusted to account for inflation, but many annuity payments and other payments are not. If you receive, say, $4,000 per month and your monthly expenses are just about that, you’ll be in trouble when property taxes, insurance premiums, food, utilities, gas, clothing, medical bills, Internet service, and many other expenses rise in price over time.

The word
Image source: Pixabay.

Inflation: nominal vs. real returns

Over long periods, inflation has averaged about 3% per year, but in any given year or period, it can be much higher or lower than that. In 2015, for example, it averaged close to 0%, while it was 6% in 1982, 9% in 1975, and more than 13% in 1980.

When it comes to investing, and to estimating how much money we’ll have in the future, it’s common to overlook inflation and its effects. When you read, for example, that the stock market has averaged annual returns of close to 10% over many decades, that’s not including inflation. That’s what’s called a “nominal” return, as opposed to a “real” return, which does incorporate inflation.

Check out the following data from Wharton Business School professor Jeremy Siegel, who has calculated the average returns for stocks, bonds, bills, gold, and the dollar, between 1802 and 2012 — yes, more than 200 years! He offers his results in both nominal and real terms:

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